TAXATION AND INCOME DISTRIBUTION Chapter 14

Vocabulary Statutory Incidence Economic Incidence Tax Shifting Statutory Incidence Economic Incidence Tax Shifting Partial Equilibrium Models Tax Analysis – use of economic theory to analyze impact of taxes Equity and Efficiency – how do taxes affect the distribution of income, how do taxes affect economic efficiency Statutory Incidence - who is legally responsible for tax (who writes the check) Economic Incidence – whose purchasing power is reduced by the tax Tax Shifting – extent that statutory and economic incidence differ Partial Equilibrium Models- look at a single market, appropriate when market for commodity is small relative to economy

Tax Incidence: General Remarks Only people can bear taxes Functional distribution of income Size distribution of income Both sources and uses of income should be considered Incidence depends on how prices are determined Incidence depends on the disposition of tax revenues Balanced-Budget tax incidence Differential tax incidence Lump-sum tax Absolute tax incidence

Tax Progressiveness Can Be Measured in Several Ways Average tax rate versus marginal tax rate Proportional tax system Progressive tax system Regressive tax system Tax Liabilities under a hypothetical tax system Income Tax Liability Average Tax Rate Marginal Tax Rate $2,000 -$200 -0.10 0.2 3,000 5,000 400 0.08 10,000 1,400 0.14 30,000 5,400 0.18 Tax scheme depicted – Tax = 0.20*(Income - $3,000)

Measuring How Progressive a Tax System Is

Measuring How Progressive a Tax System is – A Numerical Example

Partial Equilibrium Models Models that study only one market and ignore possible spillover effects on other markets Economic incidence depends on: Elasticities of Supply and Demand Tax Salience: the extent to which a tax rate is made prominent to a taxpayer Economic incidence does not depend on whether it is levied on Consumers or Producers.

Unit Tax on Commodities Price S1 Before Tax After Tax Consumers Pay Suppliers Receive S0 $1.20 $1.40 Unit Tax on Commodities Consumer Pays $1.20 Producer receives $1.20 Tax on Consumers of $.40 per gallon D curve shifts down – D curve perceived by supplier-amount of money the supplier will receive Tax wedge – tax induced spread between price paid by consumer and price received by producer Tax on Producers of $.40/gal Draw new supply curve Consumer Pays $1.40 Producer receives $1.40 Economic incidence independent of statutory incidence $1.20 $1.00 D0 D1 Quantity

Perfectly Inelastic Supply SX Price Perfectly Inelastic Supply S DX DX’ Quantity

Perfectly Elastic Supply Price S Perfectly Elastic Supply SX DX DX’ Quantity

Ad Valorem Taxes Sf Price per Pound of food Pr P0 Pm Df Df’ Qr Q0 Qm Pounds of food per year

Taxes on Factors Statutory vs. Economic Incidence The Payroll Tax Tax on labor that finances Social Security Tax on Capital in a Global Economy

The Payroll Tax SL Wage rate per hour Pr wg = w0 wn DL DL’ L0 = L1 Hours per year

Commodity Taxation without Competition Monopoly Despite market power a monopolist is generally made worse off QD does down Price paid by consumers goes up Price received by the monopolist goes down Profits go down Oligopoly Can result in higher or lower profits

Economic Profits after unit tax Monopoly $ Economic Profits MXX c a P0 ATCX Economic Profits after unit tax Pn i f d h g b ATC0 DX MRX DX’ X per year X1 X0 MRX’

Profits Taxes Economic profit Perfect competition Monopoly Measuring economic profit

Tax Incidence and Capitalization PR = $R0 + $R1/(1 + r) + $R2/(1 + r)2 + … + $RT/(1 + r)T PR' = $(R0 – u0) + $(R1 – u1)/(1 + r) + $(R2 – u2)/(1 + r)2 + … + $(RT – uT)/(1 + r) u0 + u1/(1 + r) + u2/(1 + r)2 + … + uT/(1 + r)T Capitalization: A stream of tax liabilities becomes incorporated into the price of an asset

General Equilibrium Models Show how various markets are interrelated Consider a 2-commodity, 2-factor economy resulting in the following 9 possible ad valorem taxes tKF = a tax on capital used in the production of food tKM = a tax on capital used in the production of manufactures tLF = a tax on labor used in the production of food tLM = a tax on labor used in the production of manufactures tF = a tax on the consumption of food tM = a tax on consumption of manufactures tK = a tax on capital in both sectors tL = a tax on labor in both sectors t = a general income tax

Tax Equivalence Relations Partial factor tax: tax levied on an input in only some of its uses. tKF, tLF, tKM, tLM Tax Equivalence: any two sets of taxes that generate the same changes in relative prices. tKF and tLF are equivalent to tF tKM tLM tM are equivalent to tK tL t Source: McLure [1971]. 14-19

The Harberger Model Assumptions Technology Elasticity of substitution Capital intensive Labor intensive Behavior of factor suppliers Market structure Total factor supplies Consumer preferences Tax incidence framework

Analysis of Various Taxes Commodity tax (tF) Income tax (t) General tax on labor (tL) Partial factor tax (tKM) Output effect Factor substitution effect

Some Qualifications Differences in individuals’ tastes Immobile factors Variable factor supplies

An Applied Incidence Study Average Federal Tax Rates and Share of Federal Taxes by Income Quintile (2009) Income Category Average Federal Tax Rate   Share of Federal Taxes Lowest Quintile 1.0% 0.3% Second Quintile 6.8% 3.8% Third Quintile 11.1% 9.4% Fourth Quintile 15.1% 18.3% Highest Quintile 23.2% 67.9% All Quintiles 17.4% 100.0% Top 1% 28.9% 22.3% Source: Congressional Budget Office (2012a)

Chapter 14 Summary Who bears the burden of a tax? It depends on price changes, which, in turn, depend on: Time frame Disposition of tax revenue Market structure Elasticities of supply and demand Mobility of factors of production Tax salience Partial equilibrium incidence and general equilibrium incidence analyses are used to determine burdens of unit and ad-valorem taxes